Tuesday, September 29, 2015

Variable Annuities under the DOL's Proposed Fiduciary Requirements: Is Your Due Diligence Sufficient?

As
a professor teaching undergraduate classes in both insurance and investments, I
have often reviewed variable annuity contracts with my students. Different
contracts often use different terminology for the same concepts. The array of
available riders and choices inside a variable annuity also contribute to their
complexity. As a result, much time is spent analyzing different variable
annuity contracts, in order to secure for the students an appropriate
foundation for the analyses they will undertake in the future.

What I have also seen is the sale of
variable annuities by many insurance agents/registered representatives who fail to
understand the product itself – its fees, costs, potential benefits, and
limitations. For example, a common broker-sold variable annuity contract I
encounter contains a guaranteed minimum withdrawal benefit rider. With this
rider, the annual expenses of the annuity range from 3% to 4%, and perhaps
higher. This is broken down as follows, for the series of the variable annuity
which does notpossess an
up-front and substantial commission (paid via a deferred contingent sales
charge, or DCSC):

1.10%Annual expense percentage for
the spousal highest daily lifetime income rider, a very popular feature when this annuity is sold. Since this charge
is assessed on the greater of the actual account value or the “protected
withdrawal value,” when the actual account value falls below the protected
withdrawal value the effective annual expense percentage would be greater than
1.1%. Additionally, the insurance company can raise this annual charge to as
high as 2.0% a year.

0.79%
to 1.59%The annual expense ratios for
the funds are: 0.79%, 0.85%, 0.87%, 0.88%, 0.92%, 0.91%, 0.92%, 0.94%, 0.94%, 0.95%, 0.99%
1.02%, 1.03%, 1.05%, 1.07%, 1.11%, 1.12%, 1.14%, 1.21%, 1.46%, and 1.59%. These
fund annual expense ratios assume the spousal highest daily lifetime income
rider is chosen, as noted above. When the rider is chosen, the fund selection
is limited by the terms of the contract; 10% must be allocated to the fixed
income account and the remaining 90% must be allocated to the insurance
company’s selected mutual funds, rather than the much larger universe of funds
permitted under the annuity contract if no lifetime income rider is chosen. The
interest rate on the fixed income account is determined by the insurance
company each year, based upon several factors, including the returns of the
insurance company’s general account. Each optional living benefit also requires
the contract owner’s participation in a predetermined mathematical formula that
may transfer the account value between the VA’s permitted sub-accounts and a
proprietary bond fund. It is assumed that the insurance company generates
revenue for itself on its fixed income account equal to the lowest annual
expense ratio of the available sub-accounts, for purposes of this analysis.
Most of these funds are “funds of funds” and include balanced funds (with
equity and fixed income allocations) or tactical asset allocation strategies.

0.2% Each
mutual fund (i.e., sub-account) pays brokerage commissions (for certain stock
trades) and
principal mark-ups and mark-downs for bond trades. In addition, stock trades
incur other transaction costs in the form
of bid-ask spreads, market impact, and opportunity costs due to delayed or
cancelled trades. In addition, fees are paid to an affiliate of the fund out of
a portion of any securities lending revenue. In addition, cash held by a fund
results in a different kind of opportunity cost. There is no method to estimate
the impact of these “hidden” fees and charges and costs, from publicly available
information. However, it is likely that these fees and charges and costs vary
from a low of perhaps 0.2% to a high of 1.0% (or even higher). For purposes of
this analysis, it is assumed that these fees and charges amount to only 0.2%.

----Some
states and some municipalities charge premium taxes or similar taxes on
annuities. The amount of tax will vary from jurisdiction to
jurisdiction and is subject to change. The current highest charge (Nevada) is
3.5% of the premiums paid. Often this premium tax, if assessed, is deducted by
the insurance company from the premium payment. However, for purposes of this
analysis it is assumed that there is no premium tax assessed.

Given the asset allocation dictated
by the insurance company if the spousal lifetime benefit rider is chosen, it is
likely that the gross returns (before any fees and expenses) would average 7.5%
annually, over the very long term, based upon long-term historical average
returns of the asset classes included in such funds. Yet, after deduction of
fees of 4% (or greater) (decreased to 3.5% or greater after the first 9 years),
the net return to the investor is likely to be only 3.5% (or lower) over the
long term, and may be much less. However, for the first ten years of the
annuity contract, it offers a “roll-up rate” of 5% (compounded) for the
“protected value” – the value if annuitization takes place; this 5% roll-up
rate is terminated if lifetime annuitization takes place during the first ten
years.

While the annuity offers a
“guarantee” in the sense that, if lifetime annuitization is elected at a future
date, the highest daily value of the annuity will be used when applying the
annuitization rate, it is obvious that, given the high fees and costs of this
variable annuity it is highly unlikely that the variable annuity will reach a
high principal value over the long term. In fact, over a period of 20 years or
longer, there is only a very small probability that the variable annuity value,
against which lifetime annuitization is based, will exceed the rates of return
on a balanced portfolio of low-cost stock and bond funds (even assuming
investment advisory fees and fund fees for such a balanced portfolio totaling
1% a year). Hence, for longer-term investors, the “guarantee” is often
illusory.

Additionally, the annuitization rate
offered by the insurance company is quite low, compared to the rates for
immediate fixed income annuities from insurance companies with excellent
financial strength on the marketplace today. This is true even though annuitization
rates offered today are quite low, relative to those historically offered, due
to the low interest rate environment of today. Here’s a comparison:

As seen in the table above, the client would typically
be far better off shopping for a single premium immediate annuity in the
marketplace. Even purchasing a charitable gift annuity, in which the American
Council on Gift Annuities targets a residuum (the amount realized by the
charity upon termination of an annuity) of 50% of the original contribution for
the gift annuity, would usually be better. And, as noted above, if
annuitization is to occur in the future, it is highly likely that today’s
extremely low interest rate environment would moderate, resulting in even higher
annuitization rates at that time.

Given this substantial additional
limitation on this variable annuity product, it is difficult to see how any
fiduciary investment adviser who, after performing due diligence on variable
annuities such as this one, would recommend it to a client with a long-term
investment time horizon. Other investment strategies and solutions exist which
are highly likely to generate outcomes much more favorable to the client over
the client’s lifetime.

Even more rare is the client who understands
the variable annuity he or she has purchased. In fact, for broker-sold variable
annuities, in all my years of practice I never met a client who, having already
been sold a variable annuity with these or similar features, came close to
fully understanding the features of the variable annuity, and the
often-illusory nature of the “guarantee” provided. Most clients assume that the
guaranteed value will be available if the full amount is withdrawn in full;
hardly any clients realize that the variable annuity must be annuitized, over
lifetime, at a relatively low annuitization rate. And none of the clients I met
understood the high level of fees and charges assessed against the annuity
account value (or, worse yet, the higher protected value, as to some of the
percentage fees charged).

It is the obligation of the
fiduciary investment adviser to understand the product he or she is selling,
and to fully explain all material aspects of the contract to the client. Hence,
I suggest that the U.S. Department of Labor, in its issuing release, remind
investment advisers of their fiduciary obligation of due care when dealing with
variable annuities. The investment adviser should be able to comprehend, and be
able to effectively explain to the client in a manner which ensures client
understanding, many concepts relating to variable annuity products, including but not limited to the following:

1)there
is no tax advantage for holding a variable annuity in a traditional IRA, Roth
IRA, 401(k), or other qualified retirement plan;

2)the
client should normally not purchase a variable annuity with funds that the
client will likely need for current (or near-term) expenses;

3)that
withdrawals from the annuity before the client attains age 59-1/2 may be subject
to a 10% federal penalty tax [and ways to avoid such penalty, such as 72(t)
elections, rollovers to qualified retirement plans possessing age 55 withdrawal
rights without penalty, etc.];

4)the
computational methods utilized in determining any guaranteed amounts which
might be available either upon the death of the annuitant(s) or upon
annuitization, and the nature of each guarantee and any limitations on when the
guaranteed amounts are secured;

5)the
annuity’s various fees and expenses, including but not limited to annual
mortality and expense charges (and whether fees/costs vary), annual
administration expenses, contingent deferred sales charges, expenses associated
with any riders (enhanced death benefit, GMWB, etc.) provided under the
contract, the annual expenses of the variable annuity’s sub-accounts, and their
composition, including management fees, administration fees, and 12b-1 fees;
the brokerage commissions paid by any subaccounts recommended to the client, as
a percentage of the average net asset value of the subaccount, and whether such
brokerage commissions are paid to the insurance company or its affiliates
and/or to any firm associated with the investment adviser or affiliates of such
firm, and whether such brokerage commissions include any soft dollar
compensation; securities lending revenue obtained by such subaccount and the
extent to which the gross security lending revenue is shared with the
investment adviser or any other service provider and whether such service
providers are affiliated with the insurance company or the investment adviser’s
firm or any of their affiliates; additional transaction and opportunity costs
resulting from securities trading within the fund, the subaccount’s annual
turnover rate (computed as the average of sales and purchases within the fund
divided by average net asset value of the fund); the percentage of cash
holdings of the subaccount over time and the likely resulting opportunity costs
arising therefrom;

6)the
financial strength of the insurance company and the importance of such financial
strength, especially during a period of annuization;

7)the
rate of return of the variable annuity’s fixed account, the exposure of fixed
account assets to the claims of the general creditors of an insurance company
upon default; whether state guaranty funds likely protect against a default by
the insurance company and if so to which extent; whether different annuities
should be purchased – from different companies – to better protect against the
risks of insurance company default; the likelihood of insurance company default
on a historical basis given the starting financial strength of the company as
measured by the various rating agencies; the Comdex score for the insurance
company;

8)the
impact of fees and costs of the variable annuity contract on the account value
of the variable annuity, and the availability of and any limitations on the
various guarantees offered by the insurance company either as a core of the
policy or as a rider;

9)an
estimate of the likely long-term rate of return of the variable annuity
contract, as structured by the investment adviser, versus the likely long-term
rate of return of alternative investment strategies and alternate products
(including alternate variable annuity products), and an estimate of the likelihood
that the protected value of the annuity will be higher than the returns of
non-guaranteed products, over various time periods;

10)the
annuitization rates offered under the annuity contract, whether those rates are
guaranteed, how these rates may change over time, how these rates compare to
similar single premium lifetime annuity rates in the marketplace, and the
negative or positive effective rate of return the client(s) will receive during
the annuitization period assuming death of the client(s) occur at various ages.

11)any
options existing for spousal lifetime annuitization and/or term certain, or any
combination thereof, and how these options should be considered given the
medical history of the clients and their family members;

12)whether,
during annuitization, the client would be better served by annuitization of a
portion of the client’s portfolio, whether an annual inflation increase would
better serve the client in terms of providing needed lifetime income, whether
there exist optimal ages or times (from the date of purchase of the annuity
contract) to consider undertaking annuitization, and whether a ladder of
annuitized investments undertaken over time, at various ages, would better
serve the client;

13)for
nonqualified annuities: the taxation of withdrawals from the annuity contact,
the lack of long-term capital gain treatment, the lack of stepped-up basis upon
the death of the account holder(s), and the withdrawals mandated by heirs of
the annuitant(s) and the combined estate tax / federal income tax / state
income tax consequences of income in respect of a decedent; and how withdrawals
from such nonqualified annuity contract might be undertaken to take advantage
of any lower marginal income tax brackets (both during lifetime of the
annuitants, and as to beneficiaries); and the impact of withdrawals on related
income tax planning issues for a client including taxation of social security
retirement benefits, the amount of Medicare premiums paid, and alternative
minimum tax computations; and the taxation of principle and income upon
annuitization of the nonqualified variable annuity contract; the lack of
foreign tax credit availability to the client when foreign stock funds are
utilized as subaccounts of the variable annuity;

14)the
impact of any cash withdrawals upon any guarantees or features of the variable
annuity contract;

15)the
various risks attendant to the investments in any fixed income account or the
subaccounts in the variable annuity; and

16)the understanding that higher cost
investments nearly always result in lower returns for investors over the long
term, relative to lower cost investments that are substantially similar in
composition and risk exposures.

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Ron A. Rhoades, JD, CFP® sailed across the Atlantic on a tall ship, performed in theme parks and road shows in Europe and America as a Disney character, rowed on a championship crew team, marched in the Macy’s Thanksgiving Day Parade, marched in competition with a state-champion rifle drill team, undertook a solo one-week trip into the Everglades, escorted numerous celebrities around Central Florida, performed as a “Tin Man” at a mountaintop theme park called “The Land of Oz” in Beech Mountain, NC, and served as a stage manager and talent scheduling coordinator for entertainment productions at Walt Disney World. And then he graduated college.

Since then, Ron Rhoades earned his Juris Doctor degree, with honors, from the University of Florida College of Law, which was preceded by a B.S.B.A. from Florida Southern College. Ron Rhoades has 30 years of experience as an attorney, with nearly all of those years substantially devoted to estate planning, tax planning, and retirement plan distribution planning. Ron also has over 15 years as a personal financial adviser. He was a principal with an investment advisory firm where he served as its Director of Research and Chair of its Investment Committee.

The author of numerous articles published in financial industry publications and several books, Dr. Rhoades has been quoted in numerous consumer and trade publications, and has been interviewed on Bloomberg's "Masters in Business" radio show segment. He writes occasional articles for industry publications. Ron is a frequent speaker at local FPA chapter meetings and national conferences in the financial planning and investment advisory professions.

Ron Rhoades was the recipient of The Tamar Frankel Fiduciary of the Year Award for 2011, from The Committee for the Fiduciary Standard, as he “altered the course of the fiduciary discussion in Washington.” He was also named as one of the Top 25 Most Influential persons associated with the investment advisory profession in 2011 by Investment Advisor magazine, and was voted to the “Sweet 16 Most Influential” in Wealth Management’s 2013 “March Madness” competition. Dr. Rhoades was also named as one of the "Top 30 Most Influential" members in NAPFA's 30-year history in 2013. This blog was also called one of the "Top 25 Most Dangerous" in financial services.

Ron A. Rhoades, JD, CFP® became Program Director for the Financial Planning Program (B.S. Finance, Financial Planning Track) at Western Kentucky University's Gordon Ford School of Business in July 2015. He provides instruction to highly motivated, exceptional undergraduates students in such courses as Applied Investments, Retirement Planning, Estate Planning, and the Personal Financial Planning Capstone course. He has previously taught courses in Insurance & Risk Management, Employee Benefits, Money & Banking, Advanced Investments, and Business Law I and II.

Ron also serves on the Steering Committee of The Committee for the Fiduciary Standard, on whose behalf he frequently travels to Washington, D.C. to meet with policy makers in Congress and in government agencies regarding the application of the fiduciary standard to personalized investment advice.